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February 13, 2006

Public pensions in the Midwest

Rick Mattoon
Senior Economist and Economic Advisor
Federal Reserve Bank of Chicago

The aggregate unfunded balance for state and local pensions has been pegged at as high as $700 billion by Barclays Global Investors 1 Estimates of actuarial pension balances are by nature imprecise and often controversial. Actuarial estimates change as interest rates and investment returns change and demographics of future and current pensioners are revised. Further, the appropriate actuarial funding ratio or fund balance is highly related to the economic and fiscal conditions in the state or locality. Lower funding levels can be perfectly acceptable in jurisdictions with high revenue growth.

Still, while estimates of $700 billion deficits speak to the magnitude of the problem facing the public pension system, they fail to show that many public pensions are in fact well funded and positioned to meet their benefit obligations. A recent survey of 103 public retirement systems—representing roughly 88% of the public sector employees in pension programs—found public pensions holding $2.1 trillion in assets, with slightly more than 70% of public pensions having actuarial funded levels exceeding 80%.2 In aggregate, the funding levels for all plans combined (assets minus liabilities) was 87.8% in FY2004. The range for funding levels is quite broad. The Florida Retirement System has a funding ratio of 112% and is carrying a surplus of assets over liabilities of over $11 billion. At the other end of the spectrum is the West Virginia Teachers Pension Fund that has an actuarial funding ratio of only 22%. The fund has only $1.4 billion in assets with actuarial liabilities of over $6 billion.

How do state and local governments in the Midwest rank? There is considerable variation even among plans within the same state. Figure 1 provides FY2004 actuarial values for many funds of Seventh District states. In general, Illinois funds are facing the greatest challenge with three plans having funding ratios below 70%. An interesting case of in public pension funding contrasts within a state is in Indiana. While Indiana’s state employees fund is actually slightly overfunded, its teachers fund is underfunded by $8.3 billion. In aggregate, the 12 pension funds represented in this table have assets of roughly $232 billion and liabilities of slightly over $288 billion, leaving an aggregate unfunded liability of $56 billion.

Click to enlarge images.

For those pension plans with funding ratios below 80%, the real challenge is devising a funding strategy that will close the gap. Given that most of these Midwestern states are not characterized as having rapid tax base growth, dedicating a large share of state or local revenues for pensions is bound to squeeze other government programs or require new revenues. Further, options for reducing benefit payouts are quite limited. Public pensions in 40 states are protected by state laws or the state constitution.

Another issue for public pensions is the cost of living or other payment escalators. In Illinois, public pension funds get a 3% annual post-retirement increase and are exempt from state income taxation. In Indiana, annual increases are on an ad hoc basis granted by the legislature, and benefits are taxable. In Iowa, benefits can be increased by excess earnings of the pension fund but is capped at 3% regardless of fund performance. The first $6,000 of benefits is exempt from state income taxation in Iowa. In Michigan, two plans have 3% annual increases (although one is capped at $300), while other funds are dependent on employer agreement. Finally, in Wisconsin, increases in the state pension are based on excess earnings from pension investments; however, pension reductions are possible if investment returns fall. Pension income is exempt from taxation for some in Wisconsin.

It’s clear from this brief survey that there are significant disparities in public pension funding among, and even within, state and local governments; pensions are (or will become) a significant problem for you depending a great deal on where you live.

1McGraw-Hill Companies Inc., 2005, “Sinkhole!” BusinessWeek Online, June 13, available at www.businessweek.com/magazine/content/05_24/b3937081.htm
2Keith Brainard (preparer), 2005, “Public fund survey, summary of findings for FY 2004,” National Association of State Retirement Administrators, report, September, available at http://www.publicfundsurvey.org/Summary%20of%20Findings%20FY04.pdf

Posted by at February 13, 2006 3:57 PM


It should be noted that most public plans discount their liabilities at an inflated discount rate, and therefore understate the liabilities. The proper rate -- as is true with the discounting of any cash flow -- is one which reflects the risk of the cash flows, which are bond-like in this case. Yet, standard practice is to discount at a return on assets assumption which is 2% - 3% higher than bond rates. With public plans having durations of 15 - 20 years, this implies standard accounting methods understate liabilities by 30% - 60%. Thus, the funding ratios quated by Rick Mattoon are likely grossly overstated, and the situation is as bad as Barclays suggests.

Posted by: John Minahan at April 26, 2006 3:58 PM

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