The Underfunded Pension: States Take Action

Douglas J. Peebles

State and local governments with significant pension funding shortfalls are coming under increased political pressure due to new transparency rules in accounting. My colleague Joe Rosenblum examines their options.

Last week, we argued here that new rules adopted by the Government Accounting Standards Board (GASB) will bring municipal issuers to the bargaining table, rather than to bankruptcy. We’ve already seen evidence of this turn in the tide.

Growing voter dissatisfaction with overly generous public-sector benefits has encouraged certain states to take steps to reduce their future payments, and we expect others to follow. In some states, such as Illinois, the legislature has made adjustments despite vehement union opposition. In California, the governor and several of the state’s labor unions have reached tentative labor agreements that raise employee pension contributions, mandate one day of unpaid leave per month (effectively a 5% cut in pay), and roll back pension benefits to pre-1999 levels for new hires.

Other states have increased employee contributions to their plans, raised the retirement age and increased vesting requirements. In 2010, five state legislatures passed benefit reductions or increased employee contributions; 10 other states did both. For example, New York created a fifth pension tier for new employees that requires them to contribute 3% of their annual compensation to fund their pensions, and the state also extended the retirement age. It is estimated that this change will save New York $48 billion over the next 30 years.

While altering new-hire retirement benefits doesn’t reduce current benefit payments, the adjustments do have a small but immediate effect on the overall pension liability. Of course, given that most of the plans in place for current workers have some legal protection, states will have to work through the “bulge” of existing participants until the employees under newer, less expensive plans make up a greater part of the state’s public-sector workforce.

Some states have even begun reducing the current levels of benefits, which in turn reduces the size of the bulge of the workers associated with the older plans. Notably, Colorado, New Jersey, Minnesota and South Dakota have passed changes to cost-of-living adjustments for current retirees, and the courts have upheld the changes (although the Colorado and Minnesota lower court decisions are on appeal). Other states are monitoring these developments, as current benefits were considered untouchable until recently.

In addition, many states have pushed for a switch from defined benefit to defined contribution plans to achieve cost savings. Clearly, moving to a defined contribution plan quickly and dramatically reduces retirement costs.

Our analysis indicates that the vast majority of states’ pension funds will remain healthy long enough for them to make the necessary adjustments. But although underfunded pension systems are a long-term problem, it’s one that requires attention soon: with each passing year, the long term becomes shorter for those states and localities with weaker pension systems.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams.

Douglas J. Peebles is Chief Investment Officer and Head of Fixed Income, and Joe Rosenblum is Director of Municipal Credit Research, both at AllianceBernstein.

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