Public pension plans provide millions of state and local government workers nationwide with a key source of retirement security: lifetime income. But they aren’t without their problems. Public pension plans have drawn increased scrutiny as management costs rise, retiree lifespans increase, and investment types become more complex and sometimes controversial.
Public pension plans are regulated differently from private sector plans because the U.S. Constitution grants state governments control of various administrative tasks. State and local government workers covered by a state-run defined benefit plan aren’t required to pay into Social Security or Medicare (and don’t receive benefits from those programs).
Government officials have long sought to provide competitive pension benefits to public employees without raising taxes. In some instances, that juggling act results in public pension plans being underfunded, threatening their viability.
How public pension plans are regulatedUnder the U.S. Constitution, states operate without interference from the federal government as long as their laws don’t violate the Constitution. In the case of public employee pension plans, this separation of powers means that state and local governments can provide their own pension plans, and employees are excluded from payingSocial Security and Medicare payroll taxes, mandated by the Federal Insurance Contribution Act (FICA), as long as the pensions are “sufficiently generous.” These exclusions are authorized by a Section 218 agreement of the Social Security Act. And unlike private sector pension plans, public pension plan governance isn’t subject to the Employee Retirement Income Security Act of 1974 (ERISA).
Other regulations apply. The Internal Revenue Service (IRS) lists requirements for any government-sponsored, tax-advantaged retirement plans intended to replace FICA, but does not address the investment process. The consultants, brokers, and money managers hired to manage pension plan funds are regulated through securities industry organizations such as the Financial Industry Regulatory Authority (FINRA) and the National Futures Association (NFA), and everyone involved is governed by laws forbidding fraud and theft.
Some states have their own laws in place, but many of these complicate pension plan management by dictating investment types or forbidding changes.
Problems facing public pension plansPublic pension plan solvency varies from place to place, but on average, it’s not good. Public pension plans have $1.34 trillion in unfunded liabilities as of 2024, according to Equable Institute (a nonprofit pension advocacy firm), with an average funded ratio of just 80.6%. The findings mask enormous differences from state to state and fund to fund. Tennessee pension plans, for example, reported an average funded ratio of 105%, while those in Illinois had a funded ratio of just 51%.
Incorrect actuarial assumptions. Not only have life expectancies increased, but investment returns were also lower than almost anyone forecast for the period between 2000 and 2010, setting back pension plan returns.Institutional constraints. Many states and municipalities have legal restrictions that affect pension plans. The Illinois Constitution, for example, says that pension benefits cannot be diminished or impaired. These rules make it difficult to make changes or reforms.Poor governance. Some pension plans have dealt with unethical officers or other conflicts of interest. In May 2024, Ohio’s governor received a whistleblower document alleging improper behavior by two State Teachers Retirement System members.Lack of expertise among stakeholders and decision-makers. Pension plan investing is complicated. Boards of trustees and staff members often don’t have the financial expertise needed to understand discount rates, actuarial risk, and investments.Adversarial political culture. In some communities, the political culture is broken and dealmaking is close to impossible. In others, politicians have interfered in the investment process. Some states, for example, have passed laws prohibiting investment based on environmental, social, or governance (ESG) criteria, while others enacted legislation requiring it.Conflicting incentives and interest. Elected officials are reluctant to cut pension benefits or raise taxes because neither is popular with the constituents they represent.The problem of present valuePension plan funding is determined by the estimated amount of money needed in the future, discounted into the present (the discount rate). The larger the discount rate, the less money the plan needs now to meet expected future obligations. The discount rate considers two kinds of data:
Economic assumptions that include current interest rates, expected salary increases, inflation, and investment returnsDemographic assumptions about who makes up the participant group, when they are expected to retire, and their estimated life expectancy. If a plan’s actuaries assume greater investment returns and longer times to retirement, they will come up with a smaller obligation than if they assume lower investment returns and longer life expectancies.Many public pension plans that had been in good shape in the 1990s were caught short in the early 2000s by low investment returns and increasing life expectancies, but few elected officials were interested in raising taxes or cutting benefits.
How public pension plan assets are investedThe average state pension plan investment portfolio consists of 47.1% equities (stocks), 21.2% fixed income( bonds), 6.8% real estate, 22.6% alternative investments, and 2.5% cash and other, according to data from the National Association of State Retirement Administrators. Because pension plans seek high rates of return and usually have a long time horizon, long-term illiquid investments like real estate and other alternatives make a lot of sense. These present some problems, too, including a lack of transparency and a risk to the valuation.
Although pension plans continue to pursue sophisticated investments to improve risk-adjusted returns, investing alone is unlikely to solve all the problems with pension plan funding.
The bottom linePublic pension plans provide retirement security to millions of local and state government employees that is often superior to the defined contribution plans offered by companies in the private sector. But public pension plans face numerous challenges, including sometimes severe funding shortfalls, that threaten their viability.
Plan managers’ embrace of alternative investments with their sometimes heady returns has helped some plans manage funding challenges, but more must be done. Shoring up underfunded plans takes political courage, as it typically requires raising taxes or cutting benefits—or both. These are decisions few policymakers are willing to make.
ReferencesCauses and Consequences of the Crises in State and Local Pension Funding | rand.orgInvestment | nasra.orgState of Pensions 2024 | equable.org