The national average of existing assets will cover a scant 29.5% of pension obligations if the assets are invested in a risk-free portfolio of Treasuries and TIPS. With an average return assumption of 7.21%, public pensions are 71.6% funded, on average. In effect, the nation’s actuaries and accountants are collectively projecting that excess returns from either risk premia or alpha will make up the difference, 42.1% of pension obligations, on average.
If the pension fund does not earn the 7.21% average target return, the actuaries and accountants are not on the hook for guessing wrong; that burden falls on the state’s taxpayers and/or prospective retirees. Even if the fund manages to earn the relatively lofty target return, pension beneficiaries and future taxpayers remain on the hook to close the last 28.4% of the total through reducing pension distributions or increasing contributions.
These rates of return and percentage funded ratios have real-world consequences that can be measured in dollar terms. It can be hard to wrap our heads around billions and trillions of dollars, so let’s look at the per capita dollar effects of the three funding ratios for state pension funds. Specifically, how large is the unfunded pension obligation expressed in dollars per resident of the state?
The official unfunded pension obligation, using the actuarial discount rate, ranges from $16,013 per state resident for New Jersey to –$452 (a surplus) for Wisconsin. The national average is $3,913 per state resident. This means that Wisconsin could send a check for $452 to every man, woman, and child in the state and still be fully funded. This assumes the pension fund earns its actuarial 7% discount rate, and contributions continue according to current formulas. New Jersey, however, would have to tap every man, woman, and child in the state $16,013 in order to instantly become fully funded at the state’s 7.5% actuarial rate.
The situation is not nearly as bad as it seems, however, because the pension liabilities extend decades into the future. For example, New Jersey could reduce other spending by $1,000 per state resident every year for a couple of decades into the future, divert these funds to the pension with a similar overall budget result, and not have to raise taxes—but that means fewer services for the state’s denizens.8 Even moderately serious underfunding can be a manageable problem if addressed early and the costs can be spread long enough into the future.
The magnitude of underfunding rises once we use a risk-free rate. At the year-end 2018 risk-free rate of 2.87%, underfunding ranges from $8,466 per state resident for Tennessee to $32,805 for California and to $46,774 for Alaska, averaging $18,432 per resident nationwide.9 Let me stress that these numbers are, by design, worst-case figures, because any pension can de-risk to the point of holding only Treasury bonds and TIPS. If pensions earn less than their actuarial return assumption and more than the risk-free rate, the cost of making up the shortfall lies in that midrange, too. The shortfall can be closed by using any mix of diminished benefits, such as increased employee contributions, increased employer contributions, or simply earning higher pension fund returns than appears plausible at current valuation levels.
We can also look at how the unfunded liability has changed solely because risk-free bond yields have steadily fallen since 2018; it bears mention that 60% of the drop has occurred in the first quarter of 2020. Using the 1.15% risk-free rate as of March 31, 2020, the per capita unfunded liability for Tennessee rises from $8,466 (calculated using the year-end 2018 risk-free rate) to $10,314, and for California and Alaska rises from $32,805 to $39,964 and from $46,774 to $56,982, respectively. The per capita average rises from $18,342 to $22,345.10
On a marked-to-market basis, the COVID-induced crash in bond yields has cost the average US family of four $16,000 in additional future pension obligations, taking the total in unfunded obligations per family to a national average of nearly $90,000. In Tennessee, the additional pension obligation attributable to the COVID crash works out to $7,400 per family and in Alaska the pension obligation jumped by $49,000 per family over a few short weeks! The gap doesn’t need to be closed overnight, but these are daunting numbers.