Less-than-rosy economic forecasts could mean changes on the horizon for how public pension systems are managed.
After 26 years of working as a teacher in the Alpine School District in Utah County, Karsten Walker retired this past summer. Walker is one of more than 20 million Americans who have a government pension, and he is planning carefully to take full advantage of what has been put aside for him.
Unlike most retirees, however, Walker is only 52 years old. He’s retiring early for a number of reasons, but one major motive is that he’s not so sure the pension benefits he’s entitled to will look the same in 10 years.
Walker is well aware that the current health of US public pensions is waning and that the ratio of assets on hand to the amount needed to cover current and future retirement checks is going in the wrong direction. Many state pensions have significant shortfalls—called unfunded liabilities—to the tune of well over a trillion dollars, and those shortfalls will have significant impacts on budgets, government credit ratings, and taxpayers. In some places, they already have.
For example, the state pension plans in New Jersey, Illinois, and Kentucky are currently underfunded at what many analysts believe to be unsustainable levels. New Jersey is in particularly bad shape, with funding to cover only about one-third of its forecasted pension obligations and more than $150 billion in unfunded pension liabilities. But since most pension beneficiaries have some of the strongest legal protection out there (i.e., governments will have to pay their retiree pensions come hell or high water), a growing number of states are in an impossible spot.
Fortunately for Walker, Utah’s pension system is in much better shape when it comes to having money on hand to cover those pension expenses—for now. But he’s not waiting around to see if things stay on the up and up. In his opinion, the entire US pension system is likely to crumble under its own weight soon: “The whole pension system feels like it’s unsustainable—predicated on steady or high returns and current employment assumptions,” Walker says. “There has got to be some radical rethinking of how it works.”
According to market analysts and some new critical research from a BYU Marriott professor and his colleagues, Walker might be on the right track.
There are two basic types of pensions: defined benefit plans and defined contribution plans. In government employment, the most common of these is the defined benefit plan, wherein the employer promises to pay retirees a specific payment (either a lump sum or a monthly disbursement) based on their earning history, years of service, and age. The amount of the pension payment is generally based on a percentage of the average of a worker’s earnings during the last several years of their career.
A defined contribution plan, more common in the private sector, differs in that both the employer and the employee make contributions on a regular basis, and those funds are invested. So instead of a guaranteed payment amount generated in a defined benefit plan, an employee with this plan builds up retirement income based on how their investment performs. The most common type of defined contribution plan is a 401(k). According to data from the Bureau of Labor Statistics, private sector companies began pushing workers to 401(k)s in the 1980s because the companies feared the growing cost of traditional pensions.
The vast majority of state and local government employees (upwards of 85 percent) still participate in traditional defined benefit plans. While the employer in these plans makes regular contributions, investment earnings from pension systems make up the vast majority of the final funding. In other words, public pension systems invest the employer contributions as well as the typically smaller employee contributions in an effort to produce sufficient funds to cover their payment obligations. Most pension managers hope to have their pension system fully funded in the long run and not significantly short at any given point—but many states are falling short. And things look to be tighter on the horizon. Despite 2021 being an absolute banger of a year for assets, with some investments hitting 25 percent returns, many economists believe the United States will soon enter or has already entered a low-return investment environment that could last a decade or longer.
US defined benefit pension systems are largely funded by investment portfolios, and the managers of those plans forecast their systems’ abilities to meet their obligations based on returns over the long run. That’s an expected annual rate of return of around 7 to 8 percent. If—or when—a low-return environment happens, those annual rates of return could drop down to averages of 6 to 6.5 percent or lower, resulting in a significant shortfall in the amount of money available in a pension system to pay out retirement benefits. If defined benefit pension managers in the US don’t change how they manage those systems, funded ratios will drop and unfunded liabilities in those pensions could grow to unmanageable levels.
“Pension systems are highly dependent upon investment returns in order to meet their obligations, and most plans are underfunded substantially when measured the way economists measure them,” says Don Boyd, codirector of the Project on State and Local Government Finance at the Nelson A. Rockefeller College of Public Affairs and Policy at the University at Albany. “Those pension systems have big obligations, and in most states, those obligations are unavoidable. In many cases, they are already big enough to be a significant stress on some governments.”
When the assets in government pension plans fail to keep up with growing liabilities, governments are often forced to increase contributions, which then takes away from other spending priorities across the budget. The result can be significant cuts to services for taxpayers, such as parks, recreation, and libraries. Seeing this issue become increasingly dire for local and state governments, BYU Marriott associate professor David Matkin and his research colleague Gang Chen of the University at Albany decided to create a tool that could give pension managers a better way to forecast the likelihood of trouble: a simulated pension system that takes into account all the independent components that impact real pension systems. Matkin and Chen’s work, detailed in a paper in the Journal of Pension Economics and Finance, fills an important gap and is a “big, big contribution,” according to Boyd, that effectively informs pension plan managers and state and federal governments, providing them with more accurate assessments of the risks they face.
Building a Pension Simulator
Matkin is not a licensed actuary. However, over several years of work at three different universities researching pension systems, he’s become very familiar with what pension actuaries do.
His journey to build the pension simulator started at Florida State University (FSU), where a policy research institute asked him to research practical topics for the state. At the request of the institute, Matkin started looking at pensions and began producing a series of one-off papers on local pension systems in Florida. He learned that it was a bit of the Wild West there, with some cities sponsoring three entirely separate pension systems to serve different employee types and each system having a different amount of assets and liabilities. He wanted to figure out why some systems had a higher funded ratio while others had a lower funded ratio.
“There are all of these technical elements to these plans, and they interact in so many ways,” Matkin says. “Instead of just thinking on a high level about pensions, I wanted to get down in there and become an amateur actuary and figure out how all of the independent components in these systems work together to determine the liability and funded ratio.”
After Matkin left FSU for the University at Albany, he continued his pension work, teaming up with fellow professor Gang Chen to start creating simulations of pension systems. The duo formed a partnership, and with a grant from the Social Security Administration, they started publishing papers on their research. Their work caught the attention of the John F. Kennedy School of Government, which invited the researchers to present at a special symposium on the funded status of public pension systems.
It was there that Matkin and Chen unveiled the simulated pension plan system that ultimately led them to publish their paper detailing how pension systems perform in a low-return environment. And while the authors stop short of proclaiming with certainty that a low-return environment is on the horizon, they focus their simulation on a low-return environment based on information gleaned from investment banks and those in the investment industry.
“We saw an industry survey of 35 market investor advisors or banks—BlackRock, Goldman Sachs, Merrill, Morgan Stanley, Wells Fargo—and their assumptions are the basis of the paper,” Chen says. “Their market assumptions are generally lower than what the public pension plans currently assume.”
Matkin and Chen’s simulated pension plan serves as a calculator of sorts. They built it to consider all the features of a hypothetical employer—employees, payroll, employee demographics, assets, assumptions on salary growth—and programmed it so that if all those assumptions are fed into the system, the calculator will identify the final liability or assumed present value of the long-term liability. Essentially, the calculator tells pension managers the range of possible financial conditions and contribution requirements facing their pension systems over a 10-year horizon, given a set of forecasted conditions.
To make their simulation as helpful as possible to those managers, Matkin, Chen, and their graduate student coauthor, Hyewon Kang, ran it through a variety of investment environments:
- The expected annual rate of return environment most commonly assumed by pension managers (7.5 percent)
- A low-return environment where managers invest fairly aggressively in high-return stocks
- A low-return environment where investment is balanced between equities and fixed incomes
- A low-return environment with a fairly conservative allocation that yields lower returns
What the researchers produced is essentially a series of road maps laying out the possible health of their prototypical pension plan should any of the above scenarios play out. The research illustrates what can happen to contributions and the funding level of a plan if a pension system anticipates growing at a certain rate but in reality the return is lower than that.
“Think of it like a hurricane forecast that brings together a large number of independent forecasts to identify the most likely outcome and the range of outcomes,” Matkin says. “The forecast’s strength is not really in the ‘expected’ outcome, but the range of possible outcomes. That is the risk-assessment part.”
According to the simulation, if the investments’ returns in the next 10 years are lower than the commonly anticipated 7.5 percent annual returns, the most likely result is that the pension plan’s funded ratio will fall from 80 percent (the simulation’s starting point) to 64.5 percent (not great, and well below the plan’s initial funding level). The actuarially determined contribution (ADC)—the recommended government contribution to maintain a healthy funded pension—will increase from about 20 percent of payroll (the starting point in the simulation) to 32.4 percent by the end of the decade (also not great). What’s more, Matkin and Chen’s simulations showed that in a low-return environment, there is only a 27.9 percent probability for a pension system to reach that oft-strived for 80 percent funded ratio. One more thing: the size of the required contribution would be 3.8 percent of a typical state budget and 8.9 percent of a typical local budget, with locals bearing a larger portion of the responsibility because they generally spend a greater share of their budget on personnel.
The overarching takeaway is that if pension managers don’t adjust how they’re managing the contributions and investments of their pension plans, they are bound to fall short of their payment obligations. Matkin says the research is like a stress test for an average pension system.
“As expected returns go down and systems have to rely more on contributions from the government, the impact on government budgets ratchets up,” he explains. “A pension plan could get to a point where assets are so insufficient, governments would have to pay a portion or all of their retiree benefit payments out of the budget.”
While Matkin and Chen say the impact won’t be overly dramatic for most governments—nothing like bankruptcies—consequences like pay freezes or reductions in local government services could arise.
“From what we can see, pension managers know this is coming,” Chen says. “They know the assumed 7.5 percent returns are probably too high. They know the risk of higher unfunded ratios if they push the liabilities to the future. The challenge is how to deal with it.”
Dealing with It
Managers and governments have no choice but to address the increasing disparity between their funded assets and their payment obligations. But they do have a few options. Basically, says Matkin, managers can go one of two ways with their investments: risky or cautious.
The researchers’ simulation did show that high-risk investment strategies have the highest probability of reaching and maintaining the 80 percent-funded ratio many credit analysts and bond investors look for—and the lowest ADC compared to the other lower-risk investment approaches. However, it also showed that pension systems with high-risk investments could experience significant losses in down years. That’s something pension managers are loathe to encounter. The high-risk route could also result in high volatility in contributions and increased investment fees. Still, this may be the route some pension plan managers want to take because the reward is high enough and their investment fund is small enough that this tactic makes sense. Some researchers have argued that this greater risk-taking is already occurring. For pension managers who choose this route, Matkin and Chen say it is critical to adopt management tools to accurately assess risk.
The second, more-cautious option of staying with lower returns may reduce risk, but it also could mean more costs for taxpayers since governments will likely need to increase contributions to cover those lower investment returns.
“There’s no simple middle ground here,” Matkin says. “If governments try to ease the risk to their budgets, they risk underfunding their pensions over the long term, and that is going to create big problems. If they try to be the most judicious with their pension systems, they increase their near-term costs, which means they have to make an up-front difficult decision to work against something bad that may or may not happen.”
Chen adds: “But if governments do increase near-term costs, that means they have to increase the portion of the budgets that go to the pension systems. They are competing with other needs in the budget. Where do they cut? Where do you come up with more revenue? Some are asking employees to contribute more while others are reducing the benefits they offer to new employees. There are no easy answers.”
It’s also important to remember that pension managers are not operating in a vacuum when they’re trying to make these decisions. Boyd, who works alongside Chen at the Center for Policy Research at University at Albany, says the current political environment makes it particularly difficult to make sound and secure funding and investment decisions. For example, he says, if the board of trustees of a public pension plan sees the low-return environment on the horizon and decides to take less risk and settle on a lower return, the mayor or governor might argue publicly against it because it will require increased contributions and, possibly, tax increases or service cuts.
“Politicians can and do undermine decisions in the press and elsewhere,” Boyd says. “It is extremely hard for these folks to lower their investment-return assumption. They are living in an environment that attacks them when they try to do the right thing.”
But there is a way forward. Matkin, Chen, and Boyd all suggest that pension managers start by assessing their risks right now instead of making decisions based primarily on long-standing assumptions.
“Deciding how much risk you can take is critical because the person taking the risk isn’t the government; it’s really the taxpayers and the people counting on services that may be cut,” Boyd says. “The right thing to do, in my opinion, is to reduce risk, but the problem is that you cannot reduce risk for free. A safer portfolio means not as much downside but also not as much upside, which means you’ve got to ask for more money, and you’re not going to be popular.”
Officials in Utah made such a decision in 2011 when they altered retirement benefits for newly hired employees in an effort to decrease investment risk and public cost. The changes introduced a tier system for Utah public employees: those hired prior to July 1, 2011, are part of tier 1 and are eligible for the employer-funded defined benefit plan. Those hired after that date have access to only tier 2 options and can choose between a defined contribution plan or a hybrid retirement system, which combines elements of both a traditional defined benefit plan and a 401(k)-style plan.
In both cases, tier 2 employees in Utah have to contribute on their own to fully benefit from the plans available to them. The recently retired Utah schoolteacher Walker sees it for what it is: younger teachers in Utah are going to have to teach longer and contribute more of their earnings to end up with a reasonable retirement income.
Walker understands that changes had to be made to avoid a major gap in Utah’s pension assets and liabilities, but he’s not so sure those changes will prevent further disruption. Part of the reason he retired early was so he could run for a school board position. Although he lost, he plans to continue to look for ways to preemptively address some of the changes he sees coming to the public school system, and in this case, the Utah Retirement Systems. In his opinion, low-return environments aren’t the only thing that will destabilize pensions.
“Education is an industry that is destined to see disruption. Population changes and technology changes will impact public education immensely. What happens when employment changes by, say, 30 percent?” Walker says. “A 30 percent reduction in the future head count of employee participants in pension plans may impact them just as much or more than low-return environments. Maybe employment won’t be disrupted to that extreme here in Utah, but it will happen somewhere. And when it happens, it will be another big blow.”
Written by Todd Hollingshead
Photography by Bradley Slade
About the Author
Todd Hollingshead is a media relations manager in BYU’s University Communications office. He lives in Springville, Utah, with his wife, Natalie; their four children; and a dog and a cat.