Cities and states saw pension liabilities rise in fiscal 2022 amid negative market returns even as they significantly boosted contributions with the support of federal stimulus aid.
Those are the findings of a new white paper,
It’s the second such report from the authors, Oliver Giesecke, research fellow at the Hoover Institution at Stanford University and Joshua Rauh, a senior fellow at the Hoover Institution and a professor at Standford’s Graduate School of Business.
Oliver Giesecke
“We hope to provide the benchmark report in this space,” Giesecke said of the plan for future annual reports. “It would be nice to keep transparency about this situation on an annual basis.”
Unfunded pensions continue to mark the largest single liability for most cities and states, and in fiscal 2022 totaled $1.572 trillion, up from $1.076 trillion in fiscal 2021. Driving the increase was negative investment returns of 3.2%, which underperformed assumed discount rates by almost 10%, the paper found.
The reported average funding ratio in 2022 was 75.4%, down significantly from the 83.2% ratio the previous year.
In addition to the reported liability levels, Giesecke and Rauh calculate a market valuation of the liabilities, saying that measure more accurately reflects “the fact that accrued pension promises are a form of government debt with strong rights, and should thus be measured using default-free discount rates.”
Using that measure, the market value of the 2022 unfunded liabilities totaled $5.12 trillion — dropping the funding ratio to 48.5% — which is a decrease from $6.5 trillion in 2021. Unlike the reported liability, the market-based liability dropped amid the rise in interest rates throughout 2022, which “had a big impact on the market valuation,” Giesecke said.
The rise in reported liabilities in 2022 led governments to increase their contributions in part because many found themselves flush with record surpluses from COVID 19-related stimulus packages coming out of Washington.
“Some of the contribution increases were probably already planned, but others are a reflection of the pandemic-era relief packages,” Giesecke said.
The “significant” increase in government contributions came despite federal law that restricted using the stimulus funds for pension contributions. In fiscal 2022, the contribution rate as a percentage of payroll increased to 28.3% from 26.9% in 2021, the paper found. Vermont, Connecticut and Oregon saw the largest increases, which totaled more than 10% of payroll.
All told, state and local governments contributed an average $72 toward pensions for every $1,000 in aid received, the paper said.
Efforts by governments to manage their unfunded liabilities, either through funding mandates or lower discount assumptions, carry their own risks, the paper noted.
Mandates that require certain funding targets, like those imposed by Wisconsin and Connecticut, bring the risk of “major budgetary pressure” down the road, the paper said.
The required contributions, for example, to fully fund a liability over the next 25 years would “consume at least an additional 11% of own source revenues, a substantial burden on state and local governments’ budget,” the paper said. “Several county governments, special districts and city government would be seriously challenged if a full funding amortization mandate would be adopted.”
The years-long trend by governments of lowering assumed discount rates, which continued in fiscal 2022, carries the risk that some governments will seek to boost investment returns by investing in riskier assets. As of 2017, public pension funds were invested on average 43% into equities, 19% into alternative investments, and 9% into corporate bonds.
The average discount rate in 2022 was 6.71%, down from 7.31% in fiscal 2014. As the fiscal 2022 data showed, despite the continued downward trend, the assumed rates “remain above the level that the risk profile of liabilities demand,” the paper said.