Q: How many state and municipal pension plans are there?

A: Estimates run as high as 6,000 public employee retirement systems, or PERS. The Bureau of Labor Statistics reports 14 million active workers in PERS and about 3 million retirees receiving benefits. PERS control about $920 billion in assets, or about one-third of all pension assets.

Q: The Employee Benefit Research Institute says federal pension plans are drastically underfunded. What about state and municipal plans?

A: State and local plans, on average, are well funded. Prior to the 1960s, most state and local plans were funded on a pay-as-you-go basis. In the 1970s, PERS recognized the growing liability and began funding plans on an actuarial basis. In 1978, a federal pension task force reported that PERS were about 50% funded. In fiscal 1992, GFOA found PERS to be about 85% funded. The trend is toward getting these plans fully funded.

Q: What does "85% funded" mean?

A: The public and private sectors typically use different funding measures. In the private sector, "85% funded" means the plan could pay off 85% of all current liabilities if it was terminated.

But state and local governments ask a different question because they assume they will exist indefinitely. Governments ask: What percent of assets does the plan hold now to cover the current liabilities plus benefits based on projected salary increases up to retirement? It's a more realistic funding scenario for governments.

If governments used private-sector measures, then most state and local plans would be over 100% funded.

Q: Can underfunded pensions affect state and municipal credit ratings?

A: Yes. That's a major reason why there is a trend toward better funding. Rating agencies evaluate how governments fund their future obligations, including pensions.

Q: Are there trouble spots? And is there a pattern to underfundings?

A: There are trends and indicators to be aware of Over the last few years pension funds have been adjusting their assumptions.

In general, pension funds make three major funding assumptions: future investment returns, salary increases, and inflation. The interaction of these numbers determines the employer's contribution to ensure sound funding. An adjustment either up or down can dramatically alter the required contribution.

For example, one rule of thumb dictates that a 1% increase in investment return translates into a 10% to 15% savings in costs over the long term. This occurs because of the compounding effect of that 1% gain over, say, a 20-year period.

Changing assumptions in itself is not inherently wrong, but the numbers must be defensible. In the late 1980s, for example, pension funds adjusted up their investment return assumptions notably in the midst of that bull market. But now in the early 1990s, when returns have fallen, those assumptions need to be reevaluated. Overly optimistic assumptions over time can cause serious underfunding.

Q: Does this happen more with smaller governments?

A: Not really. The perception that smaller plans and governments are less sophisticated and more susceptible to mistakes or abuses has not been borne out. Budgetary pressures are universally found in small and large jurisdictions. In fact, many governments belong to consolidated statewide systems.

Q: Are there other trouble spots?

A: Another is the selection of the actuarial funding method. The range of funding methods falls into two basic categories: level and graduated.

Level funding methods factor in future service and stay relatively constant as a percentage of payroll over a workers' career. Graduated methods only include funding for already accrued service and often contributions increase as service grows. Most PERS use level funding to keep contributions on a consistent base. However, both methods are acceptable and should complement the demographics of the covered work force. Older workers are better served by level funding. Younger groups are more adaptable to graduated methods.

Q: Is there a problem with governments simply failing to fund their pension plans?

A: That is another indicator - a government saying we simply don't have the money to put into the plan. A government might say: We're going to recognize that we're not making the contribution and we're going to amortize the unfunded liability over a longer period. Euphemistically, it's called "a funding holiday."

There is clearly a problem if it's done consistently. However, this practice is not the norm. A recent review of PERS by the GAO reports that 80% of contributions are being made.

Q: Does the federal government oversee or guarantee state and municipal pension plans in any way?

A: State and local retirement benefits are not insured by the federally run Pension Benefit Guarantee Corp. that secures certain private-sector plan benefits. Nor are PERS subject to the Employee Retirement Income Security Act (ERISA). However, state and local plans are required to meet qualification rules of the federal tax code.

All the tax benefits that make pension plans attractive flow from the tax code. To receive tax-favored treatment, PERS must meet certain tax code qualification tests. Also, through the tax code the federal government has considerable control over benefit and contribution levels. And beginning in 1996, when additional requirements go into effect for public plans, the federal government will have even greater authority.

Q: Is there growing pressure for public pensions to target their investments into public projects?

A: There is growing pressure on several fronts. One is from the federal government. A federal infrastructure commission issued a report earlier this year that talked about encouraging public pension funds to invest in infrastructure projects. And there is a working group at the Department of Labor that is looking at the possibility of establishing a clearinghouse to disseminate information about economically targeted investments to potential investors. Moreover, at the state and local levels, there continues to be an interest in investing PERS assets in-state.

Q: Does that mean buying the state's bonds?

A: Typically not. PERS are tax-exempt entities, so municipal securities generally do not make viable investments. Investing in-state is more along the lines of supporting affordable housing, economic development, or smaller business expansion.

Pension funds can enter into partnerships with federal agencies such as the Small Business Administration or Fannie Mae to purchase a package of geographic specific loans placed in their state or community that are federally guaranteed. Economically targeted investments are still ground-breaking investments. There are numerous examples of successful examples, such as New York City's housing programs. Unfortunately, it is the failed projects that get the notoriety.

There is pressure for pension funds to do more. But funds have to base investment decisions on specific fiduciary responsibilities and the creditworthiness, return, and liquidity of the investment.

Q: Can the increased pressure to make economically targeted loans cause problems?

A: Not if the plan follows its investment policy. There is a higher level of sophistication today among fund officials and public officials. Also, the people that belong to pensions are far more sophisticated. Talk to the average police officer or firefigher and you will be absolutely amazed by their level of understanding of their pension benefits.

Q: Are there any other trends you'd like to talk about?

A: Yes. First, PERS are broadening their investments. Ohio and Florida this year passed laws allowing their funds to buy more domestic equity and international securities.

Another trend is to explore shifting away from defined benefit to defined contribution plans. Currently, 90% of all workers are covered by defined benefit plans. These plans guarantee the employee a set monthly benefit at retirement, based on years of service and salary level. Defined contribution plans guarantee a set level of contributions to be made into an employee's account, which is then invested according to the participant's direction. The retirement benefit is then based on how well the investments prosper.

With a defined benefit plan, the employer bears the risk. But the employee shoulders the risk under a defined contribution plan. Governments may find defined contribution plans attractive because funding requirements could be reduced over time. However, employees, and their representatives, typically prefer defined benefit plans.

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