One of the primary factors driving state and local unfunded pension liabilities is the failure of governments to always pay their pension bills known as actuarially determined contributions. It is obvious that shortchanging a pension fund is likely to create problems down the road, so what causes states to do this?
Accounting specialists known as actuaries annually assess the finances of pension plans, and determine how much should be set aside in the coming budget year to ensure that promised pensions can be paid for. The resulting actuarially determined contribution (ADC) — formerly called the actuarially required contribution or ARC payment — should be enough to cover normal cost (for benefits earned this year) and unfunded liability amortization payments (to catch up on pension funding shortfalls). It is critical that government employers pay at least 100% of the ADC to ensure that the pension fund they are sponsoring stays on a path to long-term sustainability. Unfortunately, legislators have a poor track record in paying the full ADC.
This article in the journal State and Local Government Review examines 10-years of data (2003-2012) on the fiscal, political, and institutional frameworks that influence public finances, and concludes there is no meaningful partisan factor that drives pension funding. Republicans and Democrats are equally good and bad at paying the full ARC. For example, in 2012, actuaries determined that the 50 states should contribute $90.4 billion into their pension funds to pay for benefits promised to current workers and to pay down existing pension debt. Instead, that year the states collectively only saved $69.5 billion. And there was no overwhelming political party driving that $21 billion underpayment.
Instead, the primary factors associated with states who pay their ADC are the strength of the funded ratio (states with a strong funded status have smaller bills to pay and are more likely to pay them; states in a fiscal hole are more likely to struggle), and the political strength of the House speaker (having a supermajority allows for legislative leaders to dictate more their budget preferences, meaning fewer needs to make trade-offs that might lead to trimming the pension contributions).
Factors associated with underfunding the ADC include, a weak bond rating, collective bargaining, Social Security participation, and “legislative professionalism.” The reasons for these factors are only speculative, but our theory is that there is likely a correlation (not causation) between states with poor credit ratings and underfunding their pension plan — for example, Illinois has struggled with its state budget so much that it has felt forced to underfund its pension plans, but those fiscal struggles in general are what have driven the states bad bond rating. Similarly, collective bargaining is not necessarily causing pension underfunding, but the fiscal constraints that come along with such determinants of compensation may lead certain states to underfund their pensions and use dollars for salary. By contrast, it is surprising to see states that participate in Social Security and that have long serving legislative staff as more likely to underfund their plans. But possible reasons include that states without Social Security know their public workers are depending on them whereas states participating in the federal retirement plan treat it as a safety net, and that more professional legislative staff better understand how to manipulate budgets in a way that closes deficit gaps but undercuts the pension plan.
Ultimately, this paper concludes there is no one-size-fits-all reason for why states fail to adhere to this best practice for pension plan management. Pension underfunding is a bipartisan problem, and the specific factors ultimately are related to local fiscal decisions more than anything else.
Read the full paper in the journal State and Local Government Review.