Time and again, articles are published about states with “large unfunded liabilities.” Often, writers and anti-pension critics use large numbers to scare readers into thinking America has a pension crisis. This is a myth. Before falling for pension opponents’ messaging, readers should understand how a plan determines the unfunded liability.
In 2017, Defined Benefit covered unfunded liabilities in our “Pension Crisis is a Myth” series:
“A large public pension plan covers hundreds of thousands of active public employees and current retirees. These plans always have large liabilities because they are obligated to manage and pay out the retirement benefits of these thousands of employees and retirees over the course of decades.
When there is a difference between the total amount of benefits owed to ALL current employees & retirees and the value of the financial assets the pension plan manages, then there is an “unfunded liability.” This means that at a specific point in time, the pension plan does not have the full amount of money it will need to pay out ALL of the retirement benefits it will owe in the future to ALL of its current and former employees. But the system never needs all that money at one time. Here’s how it really works.
An employee working today who will retire and begin collecting her pension benefit in twenty years won’t collect her entire benefit all at once. She will receive her pension benefit paid out in monthly installments over the course of her retirement, which could be another twenty years. So, for our public employee working today, the pension plan in which she participates has twenty years to earn investment returns on the contributions to her pension and may then have another twenty years over which to pay out those benefits. If the pension fund today only has 85 percent of what it will owe her, that does not mean there is a pension crisis because the fund has a long time to earn investment returns and then pay out its obligations.”
Each pension plan uses actuaries to come up with the unfunded liability by calculating a variety of factors. One component of the calculation is the discount rate. The discount rate is determined by making educated assumptions predicting the performance of a plan’s investments over the course of twenty or thirty years. According to the National Association of State Retirement Administrators:
“Because investment earnings account for a majority of revenue for a typical public pension fund, the accuracy of the return assumption has a major effect on a plan’s finances and actuarial funding level. An investment return assumption that is set too low will overstate liabilities and costs, causing current taxpayers to be overcharged and future taxpayers to be undercharged. A rate set too high will understate liabilities, undercharging current taxpayers, at the expense of future taxpayers. An assumption that is significantly wrong in either direction will cause a misallocation of resources and unfairly distribute costs among generations of taxpayers.”
Although every plan in the country is run differently, the current average discount rate is 7.6 percent. According to the National Institute on Retirement Security, nationwide, the median rate of return for pension funds is 8.3 percent, which provides some buffer from the calculated discount rate.
In a few states around the country, lawmakers repeatedly skipped, deferred, or only partially paid into pension funds every budget cycle. While public employees paid their share each and every paycheck, these states have a high unfunded liability due to this type of mismanagement by lawmakers.
Taking plans and ranking them by funded status, as MSN did recently, is extremely misleading. Pension opponents often push this narrative because they have ulterior motives, such as closing a public pension plan and moving all newly hired public employees into a riskier 401(k)-style retirement plan.