The healthiest year on record for U.S. pension funds was 2001, when collectively the major retirement systems across the country reported being virtually 100% funded. Unfunded liabilities were basically $0. Since then, the funded ratio of pension plans has fallen steadily, first down to around 85% in 2007 before the financial crisis, and at a low point of 74% funded as of 2017. These numbers might sound scary, but vague. Why does funded status matter?

Funded status is important because it measures whether or not the funding of a pension plan is keeping up with the retirement benefits it has promised.

  • Unfunded liabilities measure the shortfall between assets in the fund, and the liabilities of the plan (i.e., promised benefits).
  • The funding ratio measures the relative balance between assets and liabilities. When we say the nation’s pension plans are 74% funded, we mean they have reported around $5 trillion in promised benefits, and have roughly $3.6 trillion in assets.

The funded status of a pension fund is a snapshot at a single point in time that can provide a quick assessment of fiscal health, and indicate whether further attention is warranted.

The Many Tools of Funded Status

While the funding ratio of a pension plan provides a helpful snapshot measure of funding progress on its own, it should never be considered as the only measure of fiscal health.

The dollar amount of unfunded liabilities implied by the funded ratio matters too. Especially relative to the ability for the government sponsoring the pension plan to pay for that pension debt.

Nationally the shortfall for U.S. pension funds is $1.4 trillion, or 7% of GDP in 2017. So at 74% funded, there is still plenty of money sitting around to pay promised benefits today, but the cost of backfilling the shortfall in assets that 74% funded represents — so that every pension promise can be kept — is going to require an enormous amount of capital.

For any given state, it is helpful to consider the funded status along side the unfunded liability, and the ability for the sponsoring government to cover that funding shortfall. A 90% funded pension plan with $20 billion in unfunded liabilities that are 4% of state GDP may be in more trouble than a 60% funded pension with a $1 billion shortfall that is 0.5% of state GDP.

See Equable’s interactive map for a sense of how that 70% national funded ratio breaks out from plan to plan.

Problems Beneath the Surface

A key way to think about the funded status is as a snapshot based on the accounting rules a pension plan is currently using. Things could actually be worse (or better) depending on alternative assumptions or methods.

First, the funded status of a pension plan is very sensitive to the assumed rate of return and discount rate adopted by the board. For example, Texas Teachers Retirement System used an 8% assumed rate of return for nearly two decades and going into the calendar year 2018 reported being 81% funded. In August 2018, the TRS board adopted a 7.25% assumed rate of return, which meant revaluing its promised benefits. The reported value of liabilities when from $182 billion to $200 billion, meaning the unfunded liabilities increased from $34 billion to $45 billion. The TRS funded ratio fell to 77%.[1] Nothing changed with the health of TRS except that the board improved the reasonableness of its assumptions.

Nationally, the funded status of public pension benefits could be more like 48% using different accounting principles.[2]

Second, the value of assets being measured matters. Pension funds can report their funded status using actuarial value or market value. Because actuarially valued assets typically phase in investment gains and losses over a five year period, in the years after a sharp market downturn the funded status on an actuarial basis might look better than it is in reality (though measuring things this way avoids over emphasizing one bad year of volatility). By contrast, in the year after a strong investment return, the funded status on an actuarial basis might not look as healthy as it is on a market basis.

80% Funded is Not Good Enough

Ideally, the funding ratio of a pension plan is 100%, with $0 in unfunded liabilities. Of course a pension plan might fluctuate from years to year around that mark. But over time a pension plan should be aiming to stay consistently fully funded.

In any given year the funding ratio could be 90% or 80% without cause for concern. The problems emerge when a pension fund is consistently performing at a lower than ideal level for year after year. Remaining persistently 60% or 80% funded means maintaining an unfunded liability and, as a byproduct, unfunded liability amortization payments. Continuously maintaining a low funded ratio means perpetual pension debt payments, which take money away from other public goods and services.

Several years ago a myth emerged that 80% funded was good enough. This has been resoundingly rebuffed by the actuarial community. It is reasonable to think that since, at 80% funded, there is plenty of money to pay benefits that there shouldn’t be concerns about fiscal health of a pension plan. However, the problems emerge when a pension plan is 80% funded persistently year after year. And those problems are the way persistent payments to backfill unfunded liabilities crowd out dollars otherwise intended for infrastructure spending, park improvements, or programs to support education equity.

Funded Status is an Indicator, Not a Destination

Ultimately, funded status provides a target for fiscal responsibility, and helps pensions to be regularly assessing whether the factors going into the funded status are accurately measured. Are assets growing at a rate necessary to keep promises to public workers? Are the value of those benefits being accurately measured? Is the value of assets being appropriately measured? Is the funding ratio relative to the ability of the sponsoring government to backfill any funding shortfall a concern?

Funded status is important as a measure of progress or erosion, and should be just the first step into understanding what can be done to ensure the long-term sustainability of a retirement system.

 

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[1] Source: Teachers Retirement System of Texas actuarial valuations for fiscal years ending 2017 and 2018.

[2] Josh Rauh has estimated that the funded ratio of state pension plans in FY2017 is 48.3% using the “market value of liabilities” — a measure of promised benefits that applies a discount rate associated with the risk of the liability, instead of using the assumed rate of return as the discount rate itself. This number is slightly down from 48.7% in 2015 using the same methodology (see p. 11 of “Hidden Debt, Hidden Deficits: 2017 Edition”). Using similar methodologies, the Federal Reserve estimates the funding ratio for the top U.S. pension plans at 47.5% for the fiscal year ending 2016.