Report: 21 States’ Pension Systems Not Fiscally Sound

A new report examines the financial health of state pension systems. View maps and data for each state.
by | November 29, 2012

State pension systems suffered a significant blow during the recession, but it didn’t hit all systems equally; some fared much worse than others.

A study by investment research firm Morningstar, Inc., published earlier this week assesses the financial health of each state system, highlighting a wide disparity in the actuarial adequacy of funding levels.

An alarming number of funds face a steep uphill climb in fully funding their plans. The report found 21 states’ aggregate funded ratios fell below 70 percent, which Morningstar considers the threshold for “fiscally sound” systems. Illinois (43.4 percent), Kentucky (50.5 percent) and Connecticut (53.4 percent) registered the lowest funding levels of all examined.

The common industry standard for a “healthy” system is that it’s 80 percent funded when looking at obligations to retirees, although the number is the subject of debate.

Morningstar also appraised states’ fiscal health by calculating the unfunded actuarial accrued liability per capita, approximating the amount for which taxpayers would be on the hook if each had to ante up to make the systems whole. By this measure, Alaska tops all other states with an unfunded liability of $10,235 per resident for its plans, followed by Illinois and Hawaii.

Other states have managed to largely shore up their funds. Eight states recorded unfunded liabilities of less than $1,000 per capita, while seven systems’ aggregate funding ratios exceeded 90 percent. The report lauded Wisconsin – with a 99.8 percent funded ratio for its system -- as the nation’s strongest.

While declines have slowed in recent years, the figures dating back to 2007 still signal a downward slope for most systems’ funding levels. Much of this has to do with “smoothing,” an accounting practice that considers deviation between actual and expected returns over several years, essentially spreading out pension gains or losses over longer periods. Since most assume a five-year smoothing period, many funds have not yet fully absorbed investment losses to their portfolios incurred during the recession.

Rachel Barkley, a Morningstar municipal credit analyst who authored the report, cited the financial health of Illinois’ pension system as particularly poor. Updated data released by the state last week indicates the situation has worsened, with the aggregate funded ratio further dropping from 43 to 39 percent. The culprit in Illinois has largely been due to the failure of the state to make the necessary contributions to the pension fund to maintain its actuarial integrity compounded by less than stellar returns, she said.

“It’s been chronically stressed with poor management decisions,” Barkley told Governing.

Illinois’ investment returns failed to meet assumptions, while contributions from the state and local governments ended up below the annual required contribution. The state legislature passed reforms aimed at replenishing the system in 2011, but failed to approve additional measures during a special session this fall.

The following map shows funding ratios Morningstar compiled, with green states reporting the highest ratios:

Some separate retirement funds within single states are also in far worse shape than others, but this disparity is hidden because the report uses aggregate totals for all public employee systems. Minnesota’s various retirement plans for rank and file and other covered employees were collectively 79.3 percent funded, for example, but its Legislators Retirement Plan was actually less than 9 percent funded.

Pension plans for teachers and education employees, which account for about half the public workforce, make up a sizable portion of states’ liability. Not all states, though, contribute to teachers’ pension plans. Colorado, one such state, recorded an unfunded liability per capita of $1,804 – below most others, which might give the impression that the fund is relatively healthy. But it isn’t. The system's funded ratio was 57.7 percent, far worse than most states.

It’s for this reason that Barkley suggests weighing the health of pensions both by actuarial calculations and by the per capita method when assessing the overall health of a pension system.

While Morningstar set a 70 percent threshold for fiscally sound systems, and other credit rating agencies peg it at 80 percent, the American Academy of Actuaries went a step further earlier this year, calling the 80 percent funded ratio a “myth.” Plans should aim for accumulating assets of 100 percent of pension obligations, the association said in an issue brief.

Keith Brainard, research director for the National Association of State Retirement Administrators, said the report accurately depicted the dynamics of state pension systems. He emphasized, though, direct comparisons between state plans’ financial health can be deceptive.

“Public pension plans are nuanced and distinctive creatures of state government,” he said. “Sweeping statements and broad generalities about the public pension community are usually misleading at best.”

The Morningstar report also cautions against direct comparisons. Benefit types vary, and multiple public entities are often responsible for contributions and liabilities associated with plans.

What’s more, plan management strategies and assumptions differ. Most plans assume an investment return rate of 7 to 8 percent. The Indiana Public Retirement System, though, recently adopted an assumed return rate of 6.75 percent – the nation’s most conservative rate, according to the state.

The following table shows funded ratios and unfunded actuarial accrued liability per capita ratios for each state, which Morningstar compiled from CAFR reports and data from state fiscal agencies. Please consider the caveats above before making comparisons between states. Additional figures are listed in the Morningstar report.

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