States still woefully short of pension funding goals

A bull market can mask a variety of ills in our financial system, as became abundantly clear following the financial crisis of 2008 and ensuing market meltdown. One of the many pain points revealed was that state pension plans had become woefully underfunded.

In the years since, almost every state has initiated reforms to stabilize the plans, says Greg Mennis, who directs Pew's public sector retirement systems research. "Those reforms will over time have a positive impact on the systems," he says.

That's the good news. The bad news? State and local governments around the country still don't have anywhere close to the amount of money in their coffers that they need to pay out promised pension benefits -- and the gap between what they've promised and what they've set aside continues to grow.

According to Pew's April 8 report based on 2012 data (the most current available), state-run retirement systems had a $915 billion shortfall. Include local government funding shortfalls and the funding gap jumps to more than $1 trillion.

"As it stands now, it is not sustainable," says Gene Gard, who manages state municipal bond portfolios for Dupree Funds. That doesn't mean states are going to raise taxes or lay off workers, he says. "I think there is a middle ground we can work towards."

That middle ground -- which includes states tinkering with formulas so that plans are less generous for future workers -- is proving treacherous political terrain. Many states face a backlog of infrastructure work as well as rising education and healthcare costs.

"When you look at state funds, there are significant competing pressures," says Rachel Barkley, municipal credit analyst at Morningstar. "The pension liability is going to have to compete or additional revenue has to be raised."

New Jersey provides the latest proof of pain -- and, analysts say, lack of discipline. On May 20, Gov. Chris Christie announced he was going to pull $2.43 billion slated for workers' pension plan and use it to balance the state budget.

"At a time when we're confronted with this type of challenge, I cannot also pay the sins of my predecessors," said Christie, who had earned praise for pension reforms in his first term. He admitted at the same news conference that his pension reforms so far hadn't made "much of a dent."

In a September 2013 report, Barkley calculated the unfunded liability per capita in each state and found that every taxpayer in the country would have to pay $2,600 to make up for all the shortfalls in plans across the country.

But the fiscal health of state pension plans varies drastically, says Barkley. In Illinois, probably still the most underfunded plan in the country, it would take $7,421 per taxpayer to adequately fund the plan, she calculated.

Some states, like Wisconsin and North Carolina, are doing a good job funding their pension plans, however. Maine and West Virginia are improving, say analysts. Kentucky, still the third-worst funded plan in the nation, gets high marks for instituting reforms that should improve things in a few years.

If the economy continues to improve and the stock and bond markets stay strong, the plans overall could look much more healthy in a few years.

That's still leaving a lot to chance. Pew's Mennis worries that pension plans are taking too much risk with their investments and a sudden downturn in the market could leave them exposed.

In the last seven years, use of alternative investments such as real estate, private equity and hedge funds investments has more than doubled from 11 percent to 23 percent of pension fund assets, he found. "That's more risk and more complexity," says Mennis.

What's at stake? Current pensioners don't have to worry about losing benefits they've accrued. Worst case would be a state changing the way a cost of living adjustment is calculated which might mean less income in the future.

For state workers still on the job, the risk is a change to the plans that affects how benefits are calculated going forward. For example, policymakers might change the formula for payments to be based on the average salary for the last five years of work, instead of the highest salary, which would result in a lower calculation.

For taxpayers, the downside is that underfunded pension liabilities mean there is less money go go toward other state needs -- like education, bridges or helping municipalities with funding needs.

Plus, a big gap makes state finances look weak, which factors into states' credit ratings and leads to higher borrowing costs. And, in a vicious cycle of debt familiar to many Americans, the high price of borrowing makes it even more difficult to bring down the debt levels.

That's why analysts like Barkley worry the pension funding gap is still growing and states like New Jersey, are still deferring solving the problem. As she explains: "The pension problem is going to get more expensive and cause additional pressure on the future the more you kick the can down the road."