States estimate their unfunded liabilities at just under $1 trillion ... [but] that gap increases to $1.3 trillion using the municipal yield curve and to $2.5 trillion using the Treasury curve.
In Policy Options for State Pension Systems and Their Impact on Plan Liabilities (NBER Working Paper No. 16453), co-authors Joshua Rauh and Robert Novy-Marx examine 116 state-sponsored pension plans, including all of those with more than $1 billion of assets, to estimate the extent of unfunded pension liabilities and how that issue might be addressed.
When states value their pension systems, they typically use a discount rate of 8 percent. The authors note that the principles of financial economics suggest using a much more conservative discount rate. "This means discounting either with a taxable state-specific municipal yield curve, which credits states for the possibility they could default on pension payments, or with a Treasury yield curve, which presents the benefit payments as default-free." The states estimate their unfunded liabilities at just under $1 trillion. That gap increases to $1.3 trillion using the municipal yield curve and to $2.5 trillion using the Treasury curve. The authors focus on the narrowest measure of liabilities, which is liabilities frozen as of June 2009, not accounting for future work by existing employees, new hires, or future pay increases.
These funding gaps are not only large but difficult to fill, even with relatively dramatic policy fixes. For example, eliminating generous early retirement benefits or raising the retirement age by a year would reduce liabilities by no more than 2 to 5 percent, this study finds. Reducing cost of living adjustments (COLAs) by a percentage point would have a somewhat stronger effect, reducing total liabilities by 9 to 11 percent. But even eliminating COLAs completely, or changing the Social Security retirement age, would leave state pension plans with some $1.5 trillion less than they need according to the Treasury discounting method.
A few states already have begun to move to address this problem. Minnesota and Colorado have reduced their COLAs, but they face legal challenges as a result. Rhode Island has increased the plan retirement age for employees who are not yet eligible for retirement benefits. So has Iowa, but again only for non-vested employees. Iowa has doubled its actuarial reductions, from 3 percent to 6 percent per year, effectively making early retirement less generous. Vermont has gone even further, implementing what is known as actuarially fair early retirement: it assesses early retirement penalties on workers below a certain age and service threshold. This study concludes that, while measures such as the ones being considered by these states may have modest effects on reducing unfunded liabilities, a large share of the unfunded liabilities will remain.
-- Laurent Belsie