How to Assess the Health of Public Pensions
By: Lizzy Lees, Director of Communications, NCPERS
This article was originally featured in the July 2023 issue of The Monitor.
Funding ratios—the conventional metrics used to assess the health of public pensions—lean heavily on multiple unpredictable variables, in effect guessing at the direction that important factors such as interest rates, stock market performance, fiscal policy, and other variables will move over the course of decades. In addition, much analysis takes funding levels out of context by comparing a pension fund's long-term financial needs to the funds it has available in a single year. As a result, the magnitude of unfunded liabilities is distorted. It stands to reason that failing to factor in revenues and funding that will be collected over the long periods during which benefits are paid would warp the math.
Not surprisingly, these faulty approaches produce flawed analysis and recommendations. Yet policymakers routinely rely on such distorted assessments of public pension health as the basis for devising sweeping reforms. Doing so has long-lasting implications for public-sector workers and their beneficiaries. Over many years, policymakers have reduced public pension benefits, hiked employee contributions, and even closed plans to new hires on the basis of flawed and distorted analysis.
NCPERS recently published a Research Series paper that proposes five ways, including a few innovative ones, to assess the health of public pensions. During the 2023 Public Pension Funding Forum, researchers will further explore these methods and discuss emerging funding solutions and strategies to improve the health of public pensions.
As noted in the paper, studies by NASRA and the Reason Foundation have found that low funding ratios are frequently an impetus for reforms. Further, many opponents of public pensions often use inaccurate and out-of-context comparisons of unfunded liabilities to push through harmful pension reforms.
We believe there are better, less damaging ways to evaluate the health and sustainability of public pension plans. Below, we've outlined five ways to assess the health of public pensions beyond funding levels. To learn more, read the full NCPERS Research Series paper.
Five Ways to Assess the Health of Public Pensions
1. Compare unfunded and total liabilities that are amortized over 30 years with the total economic capacity of the plan sponsor over the same period.
Too often, policymakers view unfunded and total liabilities of public pensions in isolation. Yet focusing simply on the trends in liabilities provides an incomplete picture, and that can lead to misguided decision making. If liabilities are rising rapidly, it's easy to jump to the conclusion that their rise cannot be sustained. Therefore, the focus shifts to strategies such as cutting benefits, increasing employee contributions, or closing the pension plan to new hires. However, this is a one-sided view that overlooks other important facts. For example, while liabilities are growing, it's very often the case that the economic capacity of the plan sponsors is also increasing. Liabilities must be considered in the context of the economic capacity of the plan sponsors. In the research series paper, we look at Kentucky as an example to see how this can play out with real data.
2. Assess the fiscal sustainability of the pension plan in terms of trends in the ratio between unfunded liabilities and the economic capacity of the plan sponsor
Fiscal sustainability is a well-established concept in economics. It means that the ratio of debt to economic capacity is stable or declining over time. It's a simple concept that applies to individuals and public pensions. If unfunded pension liabilities continue to rise faster than the economic capacity of the plan sponsor, liabilities are likely to become unsustainable. However, if they are rising more slowly or in concert with the economic capacity of the plan sponsor, the pension plan is sustainable. Monitoring the ratio of unfunded liabilities to the plan sponsor's economic capacity against a benchmark – such as the historical average or another benchmark – can be a powerful tool in assessing and managing the health of a pension plan.
The NCPERS study Enhancing Sustainability of Public Pensions applies the concept of fiscal sustainability to state and local pension plans in each state.1 The study refers to the application of the concept of fiscal sustainability to public pensions as the “sustainability valuation.” An analysis of the 50 states in the NCPERS study shows that using the sustainability valuation – stabilizing the ratio of unfunded liabilities to the plan sponsor's economic capacity – has several benefits:
- The sustainability valuation shifts the focus from cutting benefits and closing plans to stabilizing unfunded liabilities in relation to economic capacity.
- As unfunded liabilities stabilize, funding levels are likely to improve.
- At the same time, contribution rates, measured as a percentage of revenues, are likely to decline.
- The sustainability valuation gives plan sponsors and policymakers important information that they can use to prevent a well-funded plan from becoming unsustainable due to changes in the sponsor's economic circumstances.
The research series paper looks at how sustainability valuation can be applied to pension plans in New Jersey. It is important to note that the sustainability valuation is one more tool that can be used to assess and manage pension plans. It does not replace the value of existing tools, including actuarial valuation, plan sponsors' funding discipline, stress testing, and sound investment policies.
3. Monitor the net amortization of the plan.
Net amortization is a way of measuring whether the annual contribution rate reduces or increases unfunded liabilities, presuming all other assumptions are met. The contribution rate may result in negative or positive amortization. If the annual contribution rate decreases liabilities, its impact is referred to as positive amortization. If, in contrast, liabilities increase despite contributions, the result is negative amortization.
If amortization continues to be negative, there are solutions that can be considered. A 2022 NCPERS publication authored by Tom Sgouros of Brown University proposes that an effort should be made to stabilize unfunded liability through unfunded actuarial liability (UAL) stabilization payments, or USPs.2 The USP is the payment necessary to leave a plan in the same condition at the end of a year as it was at the beginning, presuming all other assumptions are met. Details on how to calculate the USP are shown in the report, Measuring Public Pension Health: New Metrics and New Approaches. This approach can have a significant impact on the health of a pension plan. The research series illustrates this using the example of Oklahoma Public Employees' Retirement System.
4. Monitor employers' funding discipline.
If employers skip a contribution or pay less than the actuarially determined contribution (ADC), it throws everything off balance. It's hard to make up the loss created by skipping the contribution or paying less than is required because the asset base that grows through a compound rate of return on investments continues to be smaller. Pension plan managers should monitor contributions closely and press for employers to pay 100 percent of their ADC.
A study by the Center for Retirement Research at Boston College shows that pension plans in which plan sponsors skipped or underpaid their required pension contributions had relatively low funding ratios.3 Conversely, a study by the National Institute on Retirement Security found that pension plans in which plan sponsors made the full required contribution were well funded and remained well funded through the 2001 and 2007–2008 recessions.4
In short, it is important to assess funding discipline – that is, the habit of always making the full required contribution – in the past as well as going forward. As various studies show, funding discipline has a profound impact on the health of a pension plan.
5. Monitor trends in the fund-exhaustion period.
In actuarial terms, the fund-exhaustion period is the point in time at which a pension fund would no longer be able to pay benefits if assets were frozen at current levels. A rough way to look at the fund-exhaustion date is by simply considering the ratio of current assets to annual benefit payments. Figure 5 from the research update shows how the ratio of assets to benefit payments fluctuated during the decade in relation to the average ratio. It also shows that there was an improvement in the financial health of state and local pension plans from 2009 to 2019. For example, in 2009 state and local pension plans had enough assets to pay benefits for about 12.8 years. The figure for 2019 was 13.8 years, meaning that if everything were frozen, state and local pension plans could pay benefits for the next 13.8 years.
There are more sophisticated methods to estimate the fund-exhaustion period, which involve projections of assets, contributions, and benefit payments. But the simple calculation is something that trustees can do on the back of an envelope and get a sense of the direction in which the financial health of the plan is moving. Using the fund-exhaustion period to assess the health of a pension plan is especially important for plans that are projected to run out of money in a few years.
Read the full research paper, and find additional research from NCPERS here.
1. Michael Kahn, Enhancing Sustainability of Public Pensions (Washington, DC: NCPERS, 2022)
2. Tom Sgouros, Measuring Public Pension Health: New Metrics and New Approaches (Washington, DC: NCPERS, 2022).
3. Alicia H. Munnell, Jean-Pierre Aubry, and Laura Quinby, “The Impact of Public Pensions on State and Local Budgets,” Issue in Brief 13 (Chestnut Hill, MA: Center for Retirement Research at Boston College, 2010).
4. Jun Peng and Ilana Boivie, Lessons from Well-Funded Public Pensions: An Analysis of Six Plans that Weathered the Financial Storm (Washington, DC: National Institute on Retirement Security, 2011).