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Delaying the Funding of Public Pensions May Cost up to $26.4 Billion

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Study Finds Extended Deadline for Full Funding of State and Teachers’ Pension Systems May Cost up to $26.4 Billion

Payments during extension may add up to more than three times the money freed up by the move

State leaders’ 2010 decision to postpone the deadline for full funding of the state and teachers’ retirement systems from 2025 to 2040 may cost taxpayers up to $26.4 billion, according to a new study published by Pioneer Institute.

The Costs of Delaying the Funding of Public Pensions in Massachusetts

Pushing out the funding deadline will free up an estimated $11.9 billion that would have otherwise been dedicated to pension payments between 2011 and 2025. But the delay will result in up to $38.4 billion in additional contributions between 2026 and 2040. The deadline was pushed back in 2010 in the wake of the financial crisis.

“State leaders need to understand fully the implications of extending these deadlines,” said Iliya Atanasov, author of “The Costs of Delaying the Funding of Public Pensions in Massachusetts.” “Taxpayers may end up paying in more than three times the amount that was freed up by the move.”

The study estimates that the state could expect to free up about $2.3 billion for other spending in fiscal years 2011-2014, but at the cost of almost $2.7 billion in forgone returns in the next 10 years, based on the investment-return assumptions of the state and teachers’ systems. Annual appropriations for each of the two funds are authorized by the commonwealth; their employee contribution rates are set by state law.

Currently, the other 103 public retirement systems in Massachusetts can set their own funding deadline (within the 2040 mandate) and the annual growth rate of their pension payments (with a four-percent state limit for those projecting to achieve full funding after 2030 and a 4.5-percent limit for the rest). In consultation with their actuaries, the funds can also determine the annual rate of return on which funding projections are based.

To ensure that leaders understand the impact of delayed funding, Atanasov recommends that the commonwealth’s Public Employee Retirement Administration Commission and each pension fund conduct and make public detailed cost estimates when funding schedules are changed and stress-test them under various fiscal scenarios. He also urges state leaders to place a ceiling on the annual rate of return pension funds assume and to impose strict penalties – including state receivership – for communities whose systems are chronically underfunded.

Both the state and teachers’ pension funds assume an 8 percent return and no Massachusetts public pension system assumed annual returns below 7 percent as of 2012, but an anticipated rate of about 6 percent fits better with long-term data, provided that benefits are at least partially protected against inflation.

As a result of overly optimistic assumptions about investment returns, 81 of the commonwealth’s 105 public pension systems had lower funded ratios at the end of 2012 than they did in 1999, despite ever-increasing pension appropriations. High return assumptions increase the leverage of the pension system, worsening the impact of market drops and increasing the strain on government budgets in such circumstances.

When annual pension contributions are reduced, the shortfall is compounded by forgone investment returns over the period of reduced funding. To make up the difference, future contributions must also include the lost interest. The higher actual investment returns are, the costlier the delay.

About the Author

Iliya Atanasov is Pioneer’s Senior Fellow on Finance, leading the research tracks on pension management, data analysis and municipal performance. He is a PhD candidate in Political Science and Government and MA candidate in Statistics as well as a former Presidential Fellow at Rice University. He also holds BAs in Business Administration, Economics and Political Science/International Relations from the American University in Bulgaria.

About Pioneer

Pioneer Institute is an independent, non-partisan, privately funded research organization that seeks to improve the quality of life in Massachusetts through civic discourse and intellectually rigorous, data-driven public policy solutions based on free market principles, individual liberty and responsibility, and the ideal of effective, limited and accountable government.