State and local governments have made promises to people who work for them. These public servants have been promised that at retirement they will get guaranteed monthly income for life. But how do pension plans keep these promises?
Keeping track of the ability to make pension payments to current and future retirees starts with an important measurement: funded status.
What is the ‘Funded Status’ of a pension plan?
This is a measurement of how much money a pension fund should have.
- Pension funds have assets — contributions paid in by government employers and employees, plus investment returns made by putting those contributions into stocks, bonds, and other ways of making money.
- Pension funds also have promises — commitments made to current retirees, and current workers who will retire in the future.
The “funded ratio” of a pension plan is the percentage of assets in the fund, relative to the promises made. If a pension plan is 100% funded, that means it has all of the money it needs to pay current retirees, plus make investments that will produce future investment returns.
When a pension fund doesn’t have all of the money it should have, this means there is an “unfunded liability” — commonly known as pension debt. If a pension fund has promised $50 billion in retirement benefits, but only has $40 billion in assets, then there is $10 billion in pension debt (or unfunded liabilities), and the funded ratio is 80%.
Why is it important?
Funded status helps to keep track of whether a pension fund is going to be able to pay out all of the benefits promised by a state or local government.
It is helpful to know what percentage of funding a pension plan has, because when that number starts to drop below 100%, it could be a warning sign of trouble. It is also helpful to know what the funding shortfall is as a dollar amount — because this lets us know how much needs to be paid into the pension fund at some point, to be sure benefits can be paid.
What problems could poor funded status create?
1. “Crowd out”: When a pension fund has unfunded liabilities, that means there is a need for pension debt payments. The increased contributions from state governments mean less tax money available for roads, parks, education, housing, or other public services.
2. Instability: A pension plan with eroding funded status — like the funded ratio falling because of weak investment returns — will create growing pension debt payments. And this uncertainty in the cost of providing pension benefits from year to year can create government budget instability.
3. Insolvency: Over time, if a pension fund does not receive enough money in contributions and investment returns, it could run out of money to pay promised benefits. There are only a few states facing this problem today, but funded status is the way to monitor this risk.
What is a healthy funded status?
Pension plans are designed to be 100% funded. That should be the target of any state or local government with a pension plan.
Why? The whole point of setting up a pension fund in the first place is to put money aside (contributions from governments and employees as participants) and invest that money, using the investment returns to help pay future benefits. In this way, governments are “pre-funding” the benefits they’ve promised.
So when a pension fund has less than 100% of the money needed, that means there isn’t enough money from the pension fund in the financial markets to earn investment returns.
Is it okay if the funded status is just 80%?
Not really. For a year or two, it isn’t a problem if your state’s pension plan isn’t 100% funded. But low funded status shouldn’t be permanent.
The value of pension funds can fluctuate from year to year. Even after a big financial crash, markets tend to bounce back. In fact, some of the best investment returns for pension funds happened in the years right after the Financial Crisis of 2008-09. So it’s reasonable that funded status will fluctuate over time.
But being continuously 80% or 90% funded isn’t good enough. And for two reasons:
- First, pension debt payments can be expensive, and can take money away from investing in roads, parks, or education. For example, states collectively are spending billions of dollars every year on teacher pension debt, and are using budgets otherwise intended for school districts. This is bad just for one year… but doing it every year can create really terrible outcomes for society.
- Second, the assets of a pension fund are not only to pay current retirees. They are also supposed to be invested to earn returns that will be used to pay future retiree benefits. Staying at a poor funded status forever means keeping future retirees constantly at risk of not getting all promised benefits.
When should I be worried about the funded status in my state?
Yellow Light: Once the funded ratio drops below 90% for two or three years in a row, that is a warning sign that something isn’t exactly right. Maybe the government contributions aren’t enough. Or maybe there have been several years of losses. Or maybe some of the assumptions for the pension plan aren’t working out.
Whatever the issue, having a funded ratio between 70% to 90% for several years in a row means that unfunded liabilities are persisting. That pension funding shortfall will need to be repaid. And just like carrying credit card debt for a long time, the longer that a state takes to pay off its pension debt, the more expensive it will be in the long-run.
Red Light: Once the funded ratio of a pension fund drops below 80% for two to three years, or falls below 70% at any point, then all stakeholders should be concerned. At that point, all people who want the pension fund to be able to make its promises should demand to know if there is a serious plan in place to get the pension debt paid off, restoring the funded status to 100%.
Want to read more?
– See Equable’s series on Pension Basics, including an article about Funded Status.
– Read an in-depth article from Equable Institute’s research team on the tools of measuring Funded Status.