Full funding of public pensions is one of the most hotly debated subjects in state legislatures across the nation. It’s generally accepted that public pensions should aim to be 100 percent funded. However, does full funding actually relate to the ability of a pension plan to pay benefits each year? A new report from NCPERS sheds some light on this question.
The NCPERS report looks back on the past quarter-century’s data from the annual survey of public pensions conducted by the U.S. Census Bureau. The report examines only state pension plans as the Census Bureau does not collect data on local pension plans. The report then compares the difference between total contributions & investment earnings and benefit payments in a given year. It finds that pension funds have received enough revenue to meet their benefit obligations in every year except for four (2002, 2008, 2009, 2012) and that in those years the fund had enough assets built up in reserve that it was still able to pay full benefits.
Public pensions today do not operate on a “pay-as-you-go” basis as many did in the past. A “pay-as-you-go” plan simply pays the full benefit amounts owed in a given year, typically with money appropriated directly from the state budget. In public pension plans today, workers and their employers each contribute a certain amount each year. These contributions are then invested by the staff of the pension fund. It is this combination of employee and employer contributions and investment earnings that pays the benefits that are owed to retired workers. In a given year, however, the amount of money contributed and earned through investments typically exceeds what is actually paid out in benefits that year. NCPERS refers to this as a “cushion.” Because of these “cushions”, public pensions accumulate assets over time. This enables them to still pay benefits in years- such as 2008 and 2009 during the Great Recession- when the combination of contributions and investment earnings is less than the amount owed in benefits.
Funded ratio is an important measure to consider when examining the health of a public pension plan, but it is only one measure. NCPERS argues that an obsessive focus on this one measure distorts the larger picture of the health of a pension plan. They conclude: “…our analysis suggests that pension funds can continue to meet their benefit obligations in perpetuity, regardless of their current funding levels. This is because there are usually more good years than bad years as far as investment returns are concerned, and good years allow pension funds to build up a cushion that can cover the shortfall during recession years.”