Frequently Asked Questions: The Widening Gap

Q: Why does Pew’s report, The Widening Gap, primarily use data from fiscal year 2009?

A: In The Widening Gap, we studied official state data available on or before February 1, 2011. By that date, 49 states had released pension data for fiscal year 2009, and 16 states had released complete fiscal year 2010 pension data. For retiree health care and other benefits, the most recent data available ranged from 2007 to 2010.

The main data sources for The Widening Gap are the Comprehensive Annual Financial Reports produced by each state and pension plan and other state documents that disclose financial details about public employee retirement systems. The states set their own timetables for releasing this information, and in some cases there is a significant lag time.

Q: Why are pension and retiree health care data from 2010, 2009 and earlier relevant today?

A: While data that are a year or two old cannot tell us a state’s exact retirement fund balance today, these numbers do tell us whether a state is generally on track to save enough for the retirement benefits it has promised.

When a state falls far behind on its retirement savings—as too many have in the past decade—it faces the same basic choices as an individual: put more dollars aside in future years to catch up; reduce the expected benefits; or both.

Q: Are underfunded state retirement systems a passing problem caused by the 2008 Wall Street collapse and the recession?

A: No. Even before the full effects of the recession were seen, the states were at least $1 trillion, or about one-third, short of the amount needed to pay the retirement benefits they had promised to current employees and retirees (see Pew’s 2010 report, The Trillion Dollar Gap). Going back even further, Pew found substantial shortfalls in states’ pension and retiree health care funds at the end of fiscal year 2006 (see Pew’s 2007 report, Promises with a Price).

The economic recession and investment losses have played a role, but to a significant degree the problem reflects many states’ own policy choices and lack of discipline over the last decade. Too often, policy makers have kicked the can down the road, failing to make payments toward past promises and providing additional benefits without understanding the costs or figuring out how to pay for them.

Q: Some states are reporting that their retirement fund investments made strong gains more recently. Will these gains fix the problem of underfunded pension and retiree health care systems?

A: No, for many states, investment gains alone will not fix the problem. A number of pension plans have reported strong investment gains in 2009 and 2010, and those will help put some retirement systems back on solid financial footing. But even states with well-funded systems cannot sit back and hope that investment gains will close the entire pension and retiree health care shortfall.

Consider a pension plan that expects, on average, an 8 percent annual return on its investments, but in calendar year 2008 experienced a 25 percent loss (the median investment decline for public sector pension plans that year). The plan’s investments would need to earn an average annual return of 15 percent for six years in order to accumulate as much value as would have been accrued had the 2008 losses not occurred.

Q: When complete 2010 data are released, will they show that state retirement systems have recovered due to investment gains?

A: Most states will experience continuing declines in funding levels in 2010 despite strong investment returns. This is because of a practice called smoothing, in which states acknowledge investment gains and losses over time to keep their funding levels from fluctuating wildly because of the market.

The typical smoothing period is five years, which means that the investment losses experienced in fiscal year 2009 will only be fully accounted for in 2013. We saw a similar pattern following the 2001 recession; state funding levels didn’t start to recover until 2007 despite strong investment gains in 2004, 2005 and 2006.

Q: Why do you include retiree health care costs in your analysis? Aren’t these benefits fundamentally different from pensions?

A: Examining retiree health care plans is vital to getting a full picture of states’ long-term retirement costs. The annual bills for these benefits can escalate quickly, especially as the cost of medical care rises and larger numbers of “baby boomers” retire.

As of 2009, the 50 states had set aside just 5 percent of the $638 billion they have promised in retiree health care benefits in coming years; 19 states had nothing saved.

Retiree health care benefits can be changed more easily than pensions, in general, but both are bills that will come due eventually. And for both of these promises, it is fiscally prudent for states to set aside money each year, because any investment gains can help manage the cost to future taxpayers and employees.

Q: Are all state retirement systems in serious financial trouble?

A: No. Pew studied nearly 400 state pension and retiree health care plans and found some that have been managed responsibly. In fiscal year 2009, New York and Wisconsin had fully funded pension systems, for example, while Arizona and Oregon had saved a larger portion of their retiree health care costs than the rest of the states.

The bad news is that, in 2009, 31 states had pension systems below the 80 percent funded level recommended by most experts. And 19 states had no money set aside to cover retiree health care costs.

Almost all states have room to improve their management of long-term retirement bills and deliver better results for public employees and taxpayers.

Q: Why are some estimates of states’ unfunded retirement liabilities bigger than Pew’s?

A: Pew’s analysis uses states’ own data and assumptions about key factors, including the average return each state expects to earn on its investments. For this reason, we consider our figures conservative estimates. Other researchers have used different data and assumptions that led to different estimates.

Q: Why should states make it a priority to save for long-term retirement bills when they have historic budget shortfalls right now?

A: Policy makers that put off or shortchange their annual contributions are simply adding to the bill for future taxpayers. The consequences are similar to what happens when a credit card holder makes little or no monthly payment while charging new purchases.

Policy makers failing to make full annual retirement contributions is a major reason why states’ annual pension bills shot up 152 percent over the last decade. It’s a difficult choice in tight budget times like these, but policy makers and taxpayers should, at a minimum, fully understand the effects of making little or no payment today.

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Expert

Pew Expert: Kil Huh

Kil Huh is director of the States’ Fiscal Health Project. 

Video

State Pension Costs

Watch Sue Urahn, managing director for the Pew Center on the States, discuss the scope of the pension and retiree health benefit problem.