When public pension systems were created in the 1950s and 1960s, these plans were generally small and they invested in relatively low-risk assets like government bonds. Over time, demographics, investment strategies and other factors have changed significantly, leading to the underfunding we see today.

How We Got Here

First, plan size grew dramatically over the past half-century. This is the result of demographic shifts — government workforces are aging, producing more retirees, and those retirees are living longer — coupled with stagnant or declining state and local government employment levels, especially since the Great Recession.

“Plans have become much larger relative to the size of sponsoring governments’ budgets and taxpayers’ overall capacity to pay,” says Dr. Josh McGee, an economist who is a research professor at the University of Arkansas and a senior fellow at the Manhattan Institute. “Total liabilities were about 12 percent of GDP back in 1960 and are now more than 40 percent of GDP according to Federal Reserve data.”

To keep up with growing liabilities, pension plans have shifted away from low-risk investments in favor of stocks and other higher-risk alternatives such as private equity, hedge funds, real estate and commodities. According to Fitch Ratings, in the span of a decade, pensions tripled their average investment in these so-called alternative investments. In 2007, they averaged 9 percent of state and local public pension investment portfolios. By 2017, that number had risen to 27 percent.

In some cases, these moves boosted investment returns and diversified portfolios, but they also made plans more vulnerable to market volatility and the risk of shortfalls. Now pension fund yields are highly correlated with swings in stock returns, a 2018 Pew report on public pensions points out, and even differences that at first appear to be relatively small can have a big effect on asset values. For example, a 1 percentage point difference in annual returns on the nation’s total $3.8 trillion in state and local pension debt equates to a $38 billion impact on pension assets.

Magnifying this problem is the fact that many plans also started projecting unrealistic rates of return on their investments. This was politically expedient, since a higher assumed rate of return lowers estimated liabilities, allowing political leaders to appropriate less money from state and local budgets to support pension systems and require smaller contributions from employees to fund their retirement benefits. But unrealistic predictions about investment returns — also known as discount rates — contributed to chronic underfunding of pension plans which continues today.

Where We Are Today

According to the National Association of State Retirement Administrators (NASRA), until 2011, the median investment return assumption used by public pension plans was 8 percent. However, since 2009, more than 90 percent of plans have lowered their assumed investment returns, resulting in a reduction of the median return assumption to just below 7.4 percent. Still, even these numbers may be overly optimistic, says Dr. Joe Nation, project director of the Stanford Institute for Economic Policy Research, which studies pensions.

While most pension systems bested their predictions in the last two years — with some even posting double-digit returns in 2017 — the average return over the last 10 years has been far below the assumed rate of return of 7.4 percent. According to a Pew study of 44 funds, the average 10-year total investment funds ranged from 3.8 percent to 6.8 percent, with an average yield of 5.5 percent.

The Pennsylvania Public School Employees’ Retirement System (PA-SERS) provides a good example of how market volatility can affect liabilities. In the early 2000s, PA-SERS had a published funding ratio of more than 100 percent. Fifteen years later, after assuming an 8 percent rate of return — and only realizing an average of 6 percent — the system’s funding ratio fell to just over 60 percent. Between 2001 and 2015, PA-SERS only exceeded its assumed rate of return on three occasions.

Similarly, the California Public Employees’ Retirement System (CalPERS) — the largest pension fund in the United States — had an assumed rate of return of 7.5 percent for years. In 2017, its Board of Administrators voted to lower the discount rate to 7 percent, but the system’s realized average 10-year return (from 2008 to 2018) is only 5.6 percent, and CalPERS’ official unfunded liabilities totaled around $140 billion as of 2018.

“There have been warning bells going off for a long time now about the future of public employee pensions in California. Had we adjusted the discount rate and assumed rate of return 15 years ago, we’d probably be in pretty good shape right now,” says Nation. “Liabilities have continued to grow, and because of that, the current funded ratio for CalPERS is only about 68 percent. You can imagine what the future would look like if we have another market downturn. It’s really a scary prospect.” […]

How We Move Forward

Jurisdictions have a range of options for providing pension benefits. But ultimately, a pension system must at the minimum provide retirement security for employees; be affordable for both employees and employers; and be sustainable in terms of its design, governance and funding mechanisms.

To date, much of the pension debate has been over plan design. Traditionally, public sector pensions are defined benefit plans in which employees are promised retirement payment based on a formula of their age, years of service and final average salary. The government agency invests on behalf of the employee and thus shoulders the investment risk depending on how the plan is structured.

Pension reform initiatives often include the introduction of defined contribution plans or hybrid plans intended to reduce costs and make them more predictable. With defined contribution plans, employees have their own retirement account, funded through a combination of their own contributions with a match by their government employer. The employer does not have any liability after the employee retires and thus has less or no investment risk. Hybrid plans combine elements of defined benefit and defined contribution plans — they are partly composed of guaranteed benefits and of benefits based on investment returns — with an individual retirement savings account in which employees and employers both make contributions.

While proponents of traditional defined benefit plans say defined contribution plans are more likely to leave public employees with inadequate retirement benefits, others say massive unfunded pension liabilities mean government agencies can no longer assume the risks and foot the bill.

But experts like McGee and Nation say the fundamental issue isn’t necessarily plan design, it’s the need for governments to fully fund benefits as they are earned and respond more flexibly to changing economics and demographics.

“It’s challenging because people have strongly held preconceived notions about what a traditional defined benefit plan is versus what a defined contribution plan offers — and those are the traditional battle lines in this debate,” says McGee. “But there aren’t clear delineations between plan designs anymore and maybe there never were. I think the traditional defined benefit versus defined contribution argument is stale. We need to talk about the core things that matter for retirement security — benefit accrual, investment protection and longevity protection — and how we want to provide those things to workers.” […]

The following examples show how states and cities have reduced unfunded pension liabilities and worked toward solvency using a range of plan designs. In each case, leaders brought together stakeholders to fully understand the scope of pension problems and encouraged shared compromises that put their plans on a path toward providing employees retirement security at a price the government can afford.

Check out the full report for discussions of states like Arizona, Rhode Island, and Michigan.

This article republishes selections from “A Guide to Consensus Building & Reform for Public Pension Systems” by Governing Institute and Retirement Security Initiative, a set of interviews about the process of public pension policy change published in August 2019. Content selections are from pages 5-7, and 11-12.