U.S. public pension funds are generally sustainable in the long term even without becoming fully funded, a study from Washington-based think tank Brookings Institution shows.
The study, presented at the Brookings Papers on Economic Activity Conference on March 25, says that state and local government pension plans do not need to be fully funded in order for the plans to be able to pay benefits in the future.
Louise Sheiner, senior fellow in economic studies and policy director for the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution and co-author of the study, said in a phone interview that the study's origins came from an academic debate on the sustainability of public pension plans.
"The academic debate," she said, "was really, really focused on the appropriate discount rate for the liabilities."
Public pension plans use their expected rate of return as the discount rate for their liabilities, she said, and some academics believe that because of the higher risk resulting from the guarantee of benefits that public plans provide, a much lower risk-less rate should be used, meaning the plans are "really, really underfunded."
As a result, those academics believe there is a public pension crisis, because lower discount rates would raise liabilities and force governments to make unsustainably enormous contributions.
In response, the study takes a public finance perspective, that governments issue debt and unfunded pension liabilities are simply a form of implicit debt.
Even if assets are exhausted, plans can be sustainable as long as the government makes the service payments at an interest rate equal to the asset return assumptions on the debt they issue to pay benefits, the study says.
As an exercise, the study calculates how long it would take plans to exhaust assets at discount rates of 5%, 2.5% and zero. Of the 40 plans studied, eight plans would exhaust assets in 99 or fewer years at a 5% discount rate , 21 plans would exhaust assets in 88 or fewer years at a 2.5% discount rate, and 31 plans would exhaust their assets in 69 or fewer years at zero.
The study shows that over the past 30 years using discount rates based on the expected rate of return, the 40 public pension plans studied had an average funding ratio of 83%. First, she said, if plans used a AAA corporate-bond interest rate to calculate their discount rates, it means "they always would have been underfunded," she said. If they used that discount rate, the average funding ratio would have been 55%.
"If you really believe the real rate of return is zero," Ms. Sheiner said, "then you're in this world where having assets is not particularly valuable."
The study also says another way to assess sustainability is to "ensure that the implicit debt to (gross domestic product) ratio is no higher in 30 years than it is today." The study provides a table of one-time permanent percentage point increases in contribution rates to public plans to keep that ratio stable, based on real rates of returns of zero, 2.5% and 5%.
For example, plans would need to increase contributions by 7.2 percentage points today at a 2.5% rate of return on assets.
Ms. Sheiner added that many state and local plans have enacted pension reforms over the past 10 years, primarily in creating new tiers of benefits for new hires and altering cost-of-living adjustments. As current employees "age out" of this peak of benefits, the sustainability of these plans will improve even more.
The study is available on the Brookings Institution's website.
