The economic downturn, driven by inflation and rising interest rates, has battered investment portfolios, including those of state and local employee pension funds. With markets down about 20 percent this year, the overall funding level for government pension systems has fallen back to where it was more than a decade ago. The result: taxpayers will be asked to contribute more to make up for pension shortfalls—an increasingly common outcome over the past 20 years. In addition, the number of pension systems with asset levels approaching a critical stage has increased, and the length of time that troubled systems will take to dig themselves out of their mess has grown again. In some states, underfunded pensions have become constant sources of fiscal chaos.
As stock indices rocketed to new highs at the end of 2021, the average funding level of state and local pensions rose to about 85 percent, higher than at any time since 2007, according to the consulting firm Milliman. Total debt, or unfunded liabilities, dropped to about $850 billion. The good news, however, was short-lived. The recent rapid decline in markets has now pushed funding levels back into the mid-70 percent range, and debt has climbed back to $1.3 trillion, Milliman estimates. (Some critics, using more conservative accounting standards typical of the private sector, argue that the real debt is much higher.) Even before the market downturn, only about 10 percent of state and local government pension systems were fully funded—including the Wisconsin and South Dakota plans. That portion has almost certainly decreased.
What’s more troubling is the number of struggling plans that likely have fallen back to funding levels near, or even below, 50 percent, a point at which the cost of a bailout becomes staggering. According to Milliman, at least 21 major public pension systems holding the retirement funds of millions of government employees are now below 60 percent funded—including the massive New Jersey state funds and those of Illinois. The funds of both states have less than 40 percent of the money needed to meet future obligations.
Those plans are especially at risk because public retirement systems rely on investment income to supply about 50 percent to 60 percent of the money that governments are promising to workers. When a system is only about half funded, however, it can benefit only so much from a bullish stock market, because much of the cash that it should have invested in markets simply doesn’t exist. This is why so many steeply underfunded pension plans made little progress in improving their funding levels even during the ten-year bull market that ended in early 2020; they simply lacked the assets to take full advantage of a good market.
The public pension crisis, which for some funds has lasted more than 20 years, has thus become costly for taxpayers, and those costs will keep growing. In the past two decades, local government contributions into employee pension systems have soared to $185 billion, from only $38 billion in 2003. That’s an annualized rate of increase of more than 8 percent, far faster than state and local revenues have grown. The staggering increases have helped put pressure on state and local budgets. California’s state budget boosted its pension contributions from a few hundred million dollars a year of taxpayer money in the early 2000s to $6.7 billion in 2007. By 2017, the state’s taxpayers were forced to spend $12 billion a year on pensions. After mediocre investment returns, that sum blasted to $20 billion in 2018—a more than 18-fold increase over less than two decades.
Illinois’s annual pension contributions have now reached $9 billion on a $46 billion state budget, and even that’s not adequate to reduce the state’s debt. It’s so-called actuarially determined contribution—that is, the level at which deposits into its pension system would begin reducing the debt—is a mind-boggling $14 billion a year. That’s nearly a third of the state budget and a sum Illinois obviously can’t afford. On top of that, many taxpayers in the Prairie State live in municipalities with similar burdens. Chicago’s annual pension contribution is now more than $2 billion. New Jersey, meantime, has dedicated more than $1 billion of lottery proceeds that once went to education to its pension system, and it needs to contribute another $6 billion out of its taxpayer funds to keep its pension system from collapsing. Even those numbers, however, aren’t enough to offset the outflow of money every year from the system to retirees. As a result, New Jersey’s retirement funds must rely entirely on investment returns to get healthy. It’s an almost impossible task. Even in a good market year, the returns the system generates are meager because it is so underfunded.
The strain of trying to finance pensions adequately and reduce retirement debt plagues many states. A recent Pew study found that even in the economic expansion that preceded the Covid pandemic, only about half of all states were putting enough money into their pensions annually to reduce their debts. The rest either contributed just enough to stop their retirement systems from taking on more debt, or—in the case of places like New Jersey, Connecticut, Illinois, and Texas—put too little aside and consequently watched their obligations rise during a bull market.
Part of the problem has been that retirement systems, under pressure from critics, have been forced to reduce the overly optimistic assumptions many used to justify costly government worker pensions. A decade ago, the typical public pension system projected that it would average 8 percent returns in the stock market. Today, most pensions have cut that earnings expectation to 7 percent, in the process putting more pressure on taxpayers to cover the shortfall. But even 7 percent may be too generous. The actuarial firm Wilshire calculated several years ago that most public pensions averaged just 6.79 percent annually in the previous decade, and few market observers expect much better in the coming years.
Thanks to nearly $500 billion in federal stimulus money from President Biden’s American Rescue Plan, states, municipalities, and school districts have had plenty of money to spend in this current budget cycle. Some governors, like Connecticut’s Ned Lamont and New Jersey’s Phil Murphy, have boasted that they used surplus dollars to contribute more to their states’ pensions. But bailout plans for deeply indebted retirement systems require such contributions not just for one year but for many. For dozens of plans with gaping holes in their balance sheets, no quick solution exists, especially as Biden’s stimulus dollars fade. And with the latest market downturn, the problems just got worse.